REUTERS | Fabrizio Bensch

Who pays the piper? Contractor funding for developments

Given the current limited supply of development funding from traditional financial institutions, developers are looking for alternative sources, both to kick start new projects and to finish off projects where their existing credit limits have been exceeded.

A possible alternative source of funding may come from contractors. Some contractors appear willing to dip into their reserves in order to maintain work (and goodwill with clients) at the expense of short term cash flow. We have recently seen evidence in the market that both developers and contractors are actively seeking such arrangements.

Two models

Two main models appear to be developing:

  • An “equity participation” approach, akin to a PFI type arrangement, under which a special purpose vehicle (SPV) is set up to undertake the development, with the contractor becoming an equity participant in the SPV.
  • A “delayed payment” approach, under which the contractor forgoes interim payment in return for a premium rate of interest pending final payment.

In both cases the contractor will be looking to receive a return on its investment when the completed development generates an income stream, although we have seen some contractors willing to offer certain strategic clients an “interest free” delayed payment. However, given the current very low base rate, the difference between “interest free” and a premium rate of interest is perhaps not so significant.

Equity participation

The equity participation approach may have the advantage of generating cash up front for the developer, which will not necessarily be directed to making payments back under the building contract. It also allows the developer the flexibility to introduce funding from other sources. However, it can lead to conflicts arising between the contractor’s interests as an equity investor and as the builder.

Delayed payment

The delayed payment approach is more likely to be used than the equity participation approach in order to supplement finance on existing developments where the developer may have run out of money. However, we have also seen this model used in relation to new projects. It involves the renegotiation and variation of an existing building contract. Although this might appear to place the contractor in the dominant negotiating position, it may have limited room to manoeuvre given that:

  • Its potential return on investment still depends on the successful marketing of the completed development.
  • Its security for payment may be restricted to a second charge over the development ranking behind existing funders.

As an overarching concern, the contractor will not want to risk the financial collapse of the project by pushing the developer too far.

Other issues for the contractor

The contractor also needs to bear in mind the potential risk of having to provide continued finance for any delays to the development that may not be its fault (assuming that the developer’s other sources of funding have by this stage been exhausted). Similarly, the contractor will be looking for power to veto further variations to the scope of works.

A long term trend?

Those contractors who have been prudent with their cash flow during the economic downturn are likely to be much better placed to provide additional finance than many of the developers and, in the immediate future, it seems that such arrangements may lead to some novel contractual structures developing. However, it is unlikely that contractors will continue to be a major source of funding once market confidence returns and interest rates rise again. After all, they only have access to finite resources before they too will be seeking to borrow from traditional financial institutions.

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